The investing industry hides charges like FIFA execs hide bank accounts. Even relatively transparent vehicles like index trackers [1] are not squeaky clean – the annual fee you see printed on the factsheet as the OCF [2] or TER [3] does not tell the whole story.
This is true for every fund, but at least for index trackers these extra costs are discharged like a telltale smoky belch that’s detectable using tracking difference [4].
Tracking difference shows you how far a tracker fund (that costs money) falls short of the performance of its index [5] (that costs nothing).
For example, if the FTSE All-Share index returns 10% in a year and a particular index tracker only manages 9.5% then the tracking difference is 0.5%.
That 0.5% is the true cost of owning the fund, regardless of what the factsheet might claim.
How do I uncover tracking difference?
Until now, tracking difference has been a devil to calculate and compare across funds.
I’ve previously explored a bunch of ways. None of them has been the answer.
But now one of the investment data providers, Trustnet, has taken a very good stab at tracking difference in its new passive funds [6] section.
Hit one of the asset class categories (e.g. UK equities) and you can compare the tracking difference performance of a decent range of index funds and ETFs. (Go to the performance tab.)
Here’s an example to show you the tracking difference, um, difference, between several funds.
First we use the tool to find the low OCF leaders:
FTSE All-Share top five trackers by OCF
| Index tracker | OCF (%) |
| Fidelity Index UK P | 0.06 |
| HSBC FTSE All Share Index C Acc | 0.07 |
| Vanguard FTSE UK All Share Index | 0.08 |
| L&G UK Index I | 0.1 |
| Royal London UK All Share Tracker Z | 0.15 |
Press the [+] button to reveal more fund versions on Trustnet’s site.
Now let’s see what happens to the line-up when we rank by tracking difference:
FTSE All-Share top five trackers by 3-year tracking difference (TD)
| Index tracker | 3-year TD | TD average p.a. |
| L&G UK Index I | 0.15 | 0.o5 |
| Vanguard FTSE UK All Share Index | -0.28 | -0.09 |
| HSBC FTSE All Share Index C Acc | -0.32 | -0.11 |
| Lyxor FTSE All Share GBP ETF | -0.47 | -0.16 |
| Old Mutual UK Index A Acc | – 0.61 | -0.2 |
Positive figure shows fund beat the index.
Holding tracker funds up to the righteous light of tracking difference substantially alters the top five line-up. Every position in the ranking changes. And two of the funds have changed – previous table-topper Fidelity Index UK P drops out of the rankings altogether, when ranked by tracking difference.
The Fidelity fund’s three-year tracking difference (not listed above) of 0.7% amounts to a true cost per year of 0.23%.
That’s nearly 400% bigger than the advertised fee of 0.06% (which you can only get if you invest in the fund by tying yourself into Fidelity’s platform).
In contrast the Vanguard fund’s tracking difference reveals a real cost per year of 0.09%, which is as near as dammit to the quoted OCF of 0.08%.
Vanguard’s initial charge – levied every time you invest, and put towards stamp duty – is probably the reason why it is able to sail so close to the coast.
HSBC’s All-Share fund does not impose an initial charge but there’s no avoiding stamp duty. This means investors cop it through lower net returns that are illuminated by the tracking difference score.
Most eye-catching of all is L&G Index I, which actually beat the return of the index by 0.05% per year and effectively paid you for owning it. Very nice of them.
However L&G isn’t providing its services for free, so how did it do it and can it keep it up?
Cost begone
There are various techniques for enhancing performance – the major one being securities lending [7].
In this scenario, a fund manager lends out individual securities (e.g. shares) to short-sellers in exchange for a fee.
The risk is the short-seller’s dark arts blow up in their face, they go bust and your security doesn’t come back.
Imagine Hertz rents out your car to someone in town for the day and it splits the fee with you – only for your car to accidentally get totaled in a Destruction Derby and to come back to you in a bucket.
I’m exaggerating for effect, of course, but securities lending is a risk and not every tracker provider does it.
So if you’re attracted to a fund because it’s outperformed its benchmark, it’s worth checking the provider’s securities lending policy and deciding if you’re comfortable with that.
Another reason why L&G may have outperformed is because it samples the FTSE All-Share to create its fund – it doesn’t fully replicate it.
In other words, the L&G fund buys enough shares to do a passable impression of the index but it doesn’t match it firm for firm.
It could be that its particular selection just happened to have a gold run that won’t be repeated over the next few years.
Tracking difference can fluctuate over time and that’s why many commentators recommend plumping for a tracker that hugs its index tightly as evidence of good management practices – regardless of whether the difference is positive or negative.
On that basis, the L&G UK Index I fund still wins with a 0.15 performance versus Vanguard’s -0.28.
Lookout below
You will find some funds with incredible figures like Chariguard UK Equities‘ 7.77% three-year outperformance of the FTSE All-Share.
There’s usually a snag and with this fund it appears to be uninvestable on the platforms [8] available to the likes of you and I. (Anything this deviant is also no tracker.)
Meanwhile, the SSgA UK Equity Tracker has a positive 0.35% tracking difference, but I can only find this fund on Youinvest [9] where it seemingly comes with a murderous 10% initial charge.
Another tip – don’t pay any attention to one-year tracking difference figures.
Results over short periods can be royally skewed by something as basic as the date the fund was measured, so use the longer term figure. Hopefully Trustnet will expand the service to a five-year view, too.
When making your comparison, be sure you are comparing like with like when it comes to the indexes (Trustnet refers to them as benchmarks).
For example, FTSE All-Share funds are very different beasts to FTSE 250 funds. Filter to ensure your comparison is relevant.
In contrast there’s little meaningful difference between the FTSE Emerging Markets and MSCI Emerging Markets indices. You can safely take your pick from trackers that play for either team.
You can find out more about an index by Googling it or by comparing funds using the Funds Library fund comparison tool [10] and spotting the difference between holdings.
Be your own kingmaker
Trustnet has also thrown in a classic one to five stars rating system (except the stars look like crowns).
Rating systems are time-saving catnip but personally I think it’s important to develop a decent understanding of what an investment can do for you.
Trustnet’s methodology [11] includes a weighting to tracking error [12] and fund size, which I believe are much less important to buy and hold investors.
Personally, I’d rather be guided by tracking difference and a review of the most important features of the factsheet [13]. It needn’t take long if you have a good underlying grasp of what you’re looking for [14].
A big difference
The main improvement I’d like to see from the tool is a global tracker [15] section but hopefully that will come. In the meantime, here’s a few tips on divining tracking difference [16] yourself.1 [17]
Quibbles aside, by creating a simple tracking difference reference tool, I think Trustnet has done passive investors a great service that will help us in our mission to crush costs and to navigate the investing hall of smoke and mirrors.
Take it steady,
The Accumulator
- Note, this article refers to tracking error rather than tracking difference. The terms are often used interchangeably but this article is referring to tracking difference as Trustnet means it. [↩ [22]]